Banks' Exposure to Interest Rate Risk and the Transmission of Monetary Policy
60 Pages Posted: 19 Feb 2013 Last revised: 25 Aug 2017
Date Written: April 9, 2016
We show that banks' exposure to interest rate risk, or income gap, plays a crucial role in monetary policy transmission. While banks have, on average, positive levels of income gap - their assets are more sensitive to interest rate changes than their liabilities - there is substantial heterogeneity in the cross-section of banks in how exposed they are to interest rate risk. In a first step, we show that the sensitivity of bank profits to interest rates increases significantly with their income gap, even when banks use interest rate derivatives. In a second step, we show that the income gap also predicts the sensitivity of bank lending to interest rates, both for commercial & industrial loans and for mortgages. Quantitatively, a 100 basis point increase in the Fed funds rate leads a bank at the 75th percentile of the income gap distribution to increase lending by about 1.6 percentage points annually relative to a bank at the 25th percentile. We conclude that banks' exposure to interest rate risk is an important determinant of the lending channel.
Keywords: Interest rate risk, monetary policy, bank lending
JEL Classification: E52, G21, E44
Suggested Citation: Suggested Citation